Investing 101: How Diversification Reduces Risk

This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the advisor for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.

Quick! If you had to choose just three types of assets that should be in a well-diversified, long-term investment portfolio, what would they be?

If we polled the Get Rich Slowly audience, we’d get a range of responses to that question. However, I think plenty of folks would have answered “bonds, U.S. stocks, and international stocks.” Which is perfect, because those are the investments in the demonstration of asset allocation that I’m about to embark upon. (You are all so accommodating!)

Let’s look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The Fidelity Intermediate Bond Fund (FTHRX), which holds bonds that mature in five or so years; the Vanguard 500 (VFINX), which very closely mimics the performance of the Standard & Poor’s 500 index of large U.S. stocks; and the T. Rowe Price International Discovery Fund (PRIDX), which invests in small companies from all over the world.

We can make a few observations about these returns:

Compounding is cool. Even by just earning approximately 6% a year, the initial investment more than tripled over two decades. Earn a bit over 9%, and you could almost sextuple your investment (and have fun saying “sextuple” to your friends).

Higher return comes with higher risk. Yes, the T. Rowe Price fund posted the best long-term performance, but its worst years were really worse.

You don’t always get that higher return. While the Vanguard 500 beat the Fidelity bond fund, that was due to the extraordinary returns of stocks in the 1990s. Over the past decade, U.S. large-company stocks actually have lost to bonds. (In fact, as I wrote over at The Motley Fool, the return on such stocks from 1999-2008 was even worse than the 10-year returns during the Depression.)

Earning a little bit more can lead to big bucks. The annualized return of the Vanguard 500 was just 1.52% more than the annualized return on the Fidelity bond fund. Yet the difference in the amount $100,000 grew to after 20 years was huge; the Vanguard 500 earned an extra $108,568, 33% more than what an investor earned in the bond fund. I’ve said it before, and I’ll say it again: That’s the power of earning a little bit more — or paying a little bit less — over the long term. (It is pure coincidence that the difference between the returns of the two funds, or 1.52%, is very close to the average expense ratio charged by actively managed mutual funds. But it’s a telling illustration: If you’re paying that much annually to invest in a mutual fund, but not getting superior results in return, you could be giving up tens of thousands of dollars.)

Let’s say you are given these three investment choices for the next 20 years. How would you allocate your portfolio? If you’re an aggressive investor, you might put all your money in the T. Rowe Price International Fund. But could you stand such large declines? And what if international small companies don’t do as well over the next 20 years?

If you’re a conservative investor, however, you might go the opposite direction and put all your money in the bond fund. Your portfolio would be nice and steady, likely avoiding sleep-disrupting double-digit annual declines. But, if the future is anything like the past, you could potentially be passing up $100,000 to $200,000 in gains. Perhaps that’s playing it too safe.

Let’s try a simple solution: Investing one-third of the portfolio into each of those funds and rebalancing annually. What do you think the annual return would be?

You might pick a number that is the average of the annualized returns on those funds, which would be 7.67%. But here are the actual numbers:

Well, looky there. You got a return that beat the arithmetic average of the three returns. It significantly outperformed the S&P 500, and it did so with a lot less volatility (as indicated by its worst years not being as bad). By owning assets that move in different directions at different degrees and at different times, along with some regular rebalancing, you get a return that beats the average returns of the investments in the portfolio. The whole is greater than the sum of its parts.

Sure, that extra return is less than 1% a year. But we’ve already demonstrated how earning a little for a long time really adds up. And that return beat the return of two of the portfolio’s three components. As I wrote in May, asset allocation means you don’t have to predict which type of investment will do best — which can be dangerous, because you could be wrong.

A well-diversified portfolio provides a respectable return, with lower volatility than a portfolio of just one type of stocks. Not a bad deal at all.

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Diversification is a method that reduces risk by allocating money in a portfolio among various types of investment categories. Those categories are known as “asset classes”, and deciding how much to put in to each asset class is known as “asset allocation”. The rationale behind diversification is that a portfolio of different kinds of investments will generate higher returns with lower risk than one with only a few investments.

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Nelson

As almost every other poster has noted, stocks alone are not diverse enough. Robert should probably turn in his CFP certificate. He totally ignores real-estate (including a place to live), education, job, commodities and one’s health. I wouldn’t be surprised if he made his living off of commissions from selling stocks and bonds.

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Stephen @ Financial Services

Diversification is a way to just reduce the risk, because if for example an eager investor is just starting in the game, it can help to lessen the impact of failures due to his lack of knowledge. It can also be applied to a savvy investor, because there are factors that are far beyond the control to even the most updated economist and market analyst + human errors. That’s the game of money, always gambling but the good thing is that most of the factors can be quantified and analyzed…

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stockmanmarc

While I think diversification is important would have to agree with what Steve said. Less is best! While Walter states “True diversification would include bonds, real estate, precious metals, annuities, foreign currency, and cash or cash equivalents.”
Most folks do not keep up with investing to this extreme! Warren Buffett has stated that most people should stick to INDEX investing.

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Steven

First, a diversified portfolio’s return is equal to the sum of it’s parts, not greater or lower. If you have 2 stocks and one drops $10 and the other gains $10, your return is $0. Use a weighted average if you have a well diversified portfolio to calculate your return.

Second, a diversified portfolio’s return will always be better than the worst performing component and worse than the best performing component. Yes, you gain more than the worst, but you also gain less than the best.

Third, diversification is about mitigating risk, not about producing better returns. The two are not mutually exclusive, but higher risk = higher CHANCE of greater returns. Lower risk does not mean it cannot outperform a higher risk portfolio, but the maximum gain will be lower.

For the gamblers, how lucky do you feel?

For the non-gamblers, you are one now, so see above. But seriously, the question to ask yourself is how much are you willing to lose? If you are comfortable with losing it all, then you are in the right game. If you aren’t comfortable with losing a majority of your money, because freak drops do occur, then maybe equities aren’t your thing.

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Mark Wolfinger

“A well-diversified portfolio provides a respectable return, with lower volatility than a portfolio of just one type of stocks. Not a bad deal at all.”

Yes, this is the purpose of diversification.

The question is: how likley is ‘proper’ diversification and asset allocation going to work in the future.

Is there any reason to believe that it will (or will not) do its job?

I believe there is a big risk in depending on it to continue as it has in the past.

My simple analysis: as more and more people adopt this idea – and we see how passive investing has grown – if and when panic times comes to the stock market, will the owners of other assets dump them in a panic, or hold? That’s the big question. I fear the panic.

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yourfinances101

I am far from an investing expert, but I stick by what I know. And that is, 1) diversify, and 2) stay aggressive while you’re young.

Plus, its more fun to track your portfolio when its a little on the aggressive side.

Great post

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Greg Retzloff

Some comments are dead on correct. Roger Gibson, author of the definitive book on asset allocation for other professionals in the field, suggests that seven major asset categories be included in a well-diversified portfolio: short-term debt (such as CDs, short-term bonds [corporate and treasury] and money market funds), U.S. bonds ( intermediate), non-U.S. bonds, U.S. stocks (including small caps), non-U.S. stocks (including developed and emerging markets), real estate linked securities (including REITs and partnerships), and commodities (precious metals, agriculture and energy-related).

The relative lack of correlation among some of these categories can help to both limit portfolio volatility and risk and enhance long-term returns. This idea has been come to be known as “the only free lunch in investing.” Use index funds where you can, and you get an even better deal.

This type of portfolio strategy also eliminates the necessity of market timing, a classic source of investor self-punishment.

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Jack Calhoun

I think this simple illustration proves what it is intending to prove — that compounding is your friend, that reducing volatility increases your compound return, and that combining disparate asset classes in a portfolio can actually lower your volatility.

There is no sugarcoating the fact that we are in the midst of a lost decade for stocks. The ’70s were the last such decade, and before that was the ’30s. It is a fact of equity investing that there are long stretches in which there is an equity risk “penalty” as opposed to an equity risk premium. It’s no fun to live through, but it’s all part of the deal.

In time, though, those valleys are accompanied by dramatic peaks (as we have seen the past six months), and the long-term ride ride is smoothed to reflect the real return of stocks.

The goal of diversification is to keep investors from having all their eggs in the wrong basket by being concentrated in individual stocks or market sectors. The capital markets work themselves out over time, but the same cannot be said of, say, Fannie Mae and GM…

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FinanceAnswers

Many people don’t realize how important diversification is and how damaging downside risk can be.

Let’s look at a simple example,

Let’s say you have portfolio worth $100k. During 2008 you lost 50%, so at the beginning of 2009 your portfolio value was $50k. What percent do you have to get now to get back were you started at $100k? That’s correct 100% return, to get back to even. This doesn’t even take into account opportunity cost over this time, it’s very important to be diversified.

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Kevin M

@Walter & Rob – If you look at the holdings of each fund you will see cash, bonds, small stocks & large stocks (both US & foreign). That’s not too shabby for just 3 funds.

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plonkee

I agree with ABCs. It’s all about reducing risk, and the way to do it is to invest in sectors that aren’t closely correlated – so that when one investment goes down the other ones don’t follow (or at least stay flat).

Diversification is the same strategy as ‘not putting all your eggs in one basket’ and that’s just common sense.

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Sam

I’m trying to do a better job with diversification in our retirement accounts. I find that certain stocks or stock funds can be as safe (conservative) as bonds and certain bond or bond funds can be as risky as certian stock funds.

I have a very small part of my retirement in a traditional bond fund, I also have a small part of my retirement in what could be callled a junk bond fund. Yes both funds are bond funds but the junk bond fund does not provide me with more protection and is in fact higher risk than some of my stock funds.

Yes I have diversification in that I have money in two bond funds but I don’t have the traditional protection bonds provide in the junk bond fund.

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ABCs of Investing

I like the example used in the post (which I also liked).

A lot of people think that following some sort of financial strategy is intended to increase or maximize returns. In fact as this post shows – the main point of diversification is to reduce risk.

Imagine a diversified portfolio that gets 5% in a year and has less risk than another less-diversified portfolio that also gets 5% per year. The first portfolio is the superior one even though the final result is the same.

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Steven

A friend of mine has a wonderful take on diversification and has used this idea quite successfully for years.

He owns five dividend paying blue chip stocks and one index fund. That’s it. He reinvests the dividends quarterly and puts 20% of his income in his Index Fund 401K.

He refuses to read all the “financial pornography” because he doesn’t want to be distracted from his goal.

Less is best.

Keep it simple.

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Suzanne

I learned about this in business school – diversification in stocks and bonds reduces risk AND increases return. It’s a pretty neat concept.

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Craig

I don’t trust individual stock investing, to me it’s more of a gamble than cards or sports betting. For that reason I have a diversified mutual fund investing account set up to reduce risk.

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Mike Piper

“To me, asset allocation isn’t something that gives you a benefit. Asset allocation is something like “temperature” — it can be good or bad.”

Thanks for making this distinction. It always irks me when people refer to asset allocation as a strategy. It’s not a strategy. By default, you have some asset allocation.

Having a diversified asset allocation is a strategy.

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Mike Piper

The concept of the “rebalancing bonus,” as William Bernstein calls it is pretty neat. (The idea being, as Robert mentioned above, that an asset class’s contribution to a portfolio may in fact be greater than its stand-alone return.)

But as I was editing this, it kept occurring to me that what he was really pointing at was the benefits of diversification. To me, asset allocation isn’t something that gives you a benefit. Asset allocation is something like “temperature” — it can be good or bad. The benefits Brokamp is talking about come from diversification.

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CB

I think it’s interesting to note that the author isn’t advocating that this is the only thing you should do for retirement or that this will be the only thing you need. I agree with Walter in that trrue diversification spreads risk across multiple asset classes and diversifies in each class. However, I agree with the author that this is a reasonable way to diversify in the equties asset class and should be a part of a complete portfolio.
I think we tend to forget that our ‘portfolio’ does not just reflect what we put directly into the stock market specifically for retirement. Our portfolio spreads across our whole lives. Maybe we should look at ‘portfolio’ and think ‘net worth’ to get a more complete picture of what our portfolio is. Then we see that in the grand scheme of our portfolio, we need to have other asset classes. In terms of our retirement portfolio, depending where we are in life, what the author is suggesting is a well balanced portfolio for that point in that person’s life.
Right now I’m young and only invested in stocks and bonds with some cash on hand. In 10 years or so, I hope to be spreading my equities out a little more across stocks and bonds and to invest in other asset classes to start the type of diversification that Walter discussed.

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d^2

isn’t this relying heavily on the major uptick in the equities markets from the 90s to the middle 00’s? maybe you should run it again with those years dampened in terms of returns, and just see what we’d get as a “baseline” scenario?

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Derek Illchuk

Asset allocation with rebalancing forces you to buy and sell at the right time; after that asset class does great you sell, and after it tanks you buy. But, for this effect, you *must* sell your winners, even though you love them.

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Ray @ Financial Highway

Diversification is great if done properly, often investors think they have a diversified portfolio but when taking a closer look it almost has a perfect positive correlation, when the idea behind diversification is to have non-correlated or negatively correlated investments.

Although diversification works good in the long run there are times when all investments will move in the same direction (down) like we in 2008 where even well diversified portfolios saw substantial losses.

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Rob Bennett

I agree strongly with Walter. This is not diversification. This is diversification as promoted by The Stock-Selling Industry. I’ll take a pass on this approach.

Realistic diversification strategies are powerful helps to the middle-class investor. The key to effective diversification is lowering your stock allocation when the long-term return from stocks is likely to be very low. It can take years or even decades to recover from the failure to engage in effective diversification.

Rob

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Will

@ Mark

I don’t think he’s suggesting that diversification ensures that your investments will be “secure.” He’s saying that when you diversify, your portfolio will perform better than the sum of its parts in the long term. Think about how much worse off you would be had you invested everything into the worst performing fund in your portfolio. I would also submit that what has happened to the market since last fall isn’t exactly “long term.” My accounts were hit hard as well, but I know I won’t remember the recession in 5 years, and dollar cost averaging right through the worst part of the downfall will actually lead to huge gains in 20 years. This article was a great explanation of what you learn about diversification in finance class in business school.

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Walter

This isn’t true diversification. This is diversification in one asset class: equities. True diversification would include bonds, real estate, precious metals, annuities, foreign currency, and cash or cash equivalents.

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Mark Patterson

I bought into the asset allocation theory as well. Then I saw every asset class in my portfolio tank in 2008-2009. They still haven’t recovered. Run your numbers from 2000 through today or talk to folks who retired in 2007 based on a “well-diversified portfolio.” The argument that a well diversified portfolio invested over the long term will provide a secure retirement for everyone is mythical. Do not count on traditional investments offered by the retail investing industry to meet your basic retirement needs. They win no matter what but you can lose.

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